Sources of Finance Available to a Business - Essay Example

Managing Financial Resources and Decisions Student Name: Student No: Course: Faculty: University: Lecturer: Date of Submission: Table of Contents Introduction 3 Part 1 3 Sources of finance available to a business 3 Implications of different sources 3 Long Term Sources 3 Medium and short term 4 Appropriate sources of finance for a business project 5 Analyze the costs of different sources of finance 5 Importance of financial planning 5 Information needs of different decision makers 6 Impact of finance on the financial statements 7 Part 2 8 Part 3 9 Assessment of a project using investment appraisal techniques 9 Main financial statements 12 Comparison of formats of financial statements for different types of business 13 Interpreting financial statements using the appropriate ratios and comparisons, both internal and external 16 Conclusion 20 Works Cited 21 Introduction This formal report contains a detailed review and scenario on different sources of finance that are available to both new and existing businesses, the probable implications of the same resource within a business, some of the financial decisions that are based on the financial pieces of information, and how the financial performance of a business evolves. The rationale behind this report is to guide different business, small and large, new and old, in exploring the different sources, and the merits and demerits of those sources. Part 1 Sources of finance available to a business There are different sources of finance available to a business. They include the long term sources such as retained earnings, share capital, third-party investment, and loans whereas the short and medium term sources include leasing, hire purchase, cash management, working capital stock control, and debtor factoring. Implications of different sources Different sources have different financial, legal, and dilution of some control implications. Further, the suitability, disadvantages and advantages of the sources varies from one source to another. Long Term Sources Retained Earnings Retained earnings or personal savings, alongside other assets can be a great source of capital for a business (Martin & Fernando, 2011). Retained earnings for a company are not associated with issue costs and this prevents the chances of change in company control that normally results out of issue of new shares. The advantage with this source is that you will not be paying interests on bank loans. The drawback is that you may loss all your investment if the business goes bad. At the same time, shareholders should refrain from the use of retained profits for reinvestment because the shareholders are supposed to be paid reasonable dividends. Share Capital The issuance of shares will raise the company’s cash, and more importantly float the company’s shares on a stock exchange. Further, the shares may be issued to the shareholders of a different company so that it takes over. Third-party investment Third parties can be investors who will help raise the expansion or startup capital. The investors may be active partners or silent investors who will just wait for returns or simply provide the capital. The disadvantage of third-party involvement in financing the business is that you have to give up some components of business control. The other challenge is to keep the investors happy. Further disadvantage is that you have to share the profits with the investors. Loans Loans can be acquired from banks. In most cases, real estate, inventory and large equipment are used as collateral in securing a loan. The advantage of loans is that you can keep your cash at hand, and use it as operating capital for business survival when the business is down. Further, in case the business performs badly, you can protect personal assets through declaring of bankruptcy. However, the disadvantage of loans is that you have to pay loan interest, and the payments must be due on time regardless of business performance. Medium and short term Leasing Leases are agreements between the use of the given leased asset and the financial provider or lesser. The advantage of this method is that the lessee will be responsible for the servicing, upkeep and maintenance of the asset and that the lessee may not be allowed to sell the asset. Further, the leased asset does not have to be shown in the balance sheet of the lessee, and the equipment will be leased for a shorter period than the expected useful duration of the asset. Hire purchase Unlike leasing, the ownership of goods passes to the customer in hire purchase upon payment of the final installment whereas a lessee does not become the owner of the leased asset. Appropriate sources of finance for a business project In order to choose the appropriate source of financing for your business project, different criteria will be used (Pamela & Frank, 2012). This will include, determine the amount of money required by the project, how quick that money is required, alternative cheapest options available, and the amount of risks associated with each source. Risky projects have got less chances of resulting to profits. Further, the urgency of the project should be considered. For instance, the needs for a short-time project and a long-time project are very different. Short-term financing will be required to take care of day-to-day running of the business whereas the long-term finance will be the most appropriate for large project which normally payback over longer period. Analyze the costs of different sources of finance While the ownership capital will make you bear some responsibility to a group of shareholders who have some partial ownership rights, loans cost some interests. The interest is demanded on schedule regardless of whether you made loss or profit. Hire purchase is expensive as compared to cash payment for an asset. Leasing is also expensive as compared to other means of sourcing like retained earnings (Brian, 2010). Importance of financial planning Financial planning is very crucial to an organization. It helps an organization to be prepared in combating pitfalls and setbacks, keeping your business organized, estimating the future profits, and diversifying the business. Financial planning helps in efficient management of income. The analysis of needs, the available cash and income expenditure budgets help in showing the appropriate way of managing income. For any amount earned, some should pay taxes, expenditures, and some go to savings. Financial planning helps increase the cash flow, monitor expense and spending habits. It assists in determining what can be done in order to generate cash flow for further investments. Through financial planning, attention can be paid to aspects such as budgeting, and tax planning. Financial planning will also help in building a long-term capital basis towards shaping the financial future of the company. Increase in cash flow will result to increase in capital base as well, thus allowing a business to venture into different investment portfolios. Financial planning is also useful in evaluating the appropriate investment opportunities available. Through proper financial plans, you can turn dreams into realizable goals and realities. It shows how to allocate some monetary to different investments, and this creates some effect on investment. A company can also define a new approach to budgeting, gain some control over the financial aspects, evaluate the level s of risk in any portfolio, and readjust the investment plans accordingly. Information needs of different decision makers Decision makers have different information needs. The information can help them gauge their business performance; allocate business resources for further improvements. Decision makers require information for the following main reasons: Quantify an objective In order for decision makers to chose a criteria, they will maximize profits by minimizing the total costs using an objective function. Determine the constraints Decision makers have different constrains such as labour, limited raw material, and would therefore, require an objective to maximize profits as per the defined constraints. Determine the alternative course of action A company will have different considerations to choose from. For instance, to minimize manufacturing operations costs, different alternatives are available, but financial information will help decision makers on how to go about choosing the right decision (David, 2006) . Forecasting Decision makers will consider different sources on information in order to forecast the incremental benefits and costs of each and every alternative action. Application of objective Function Information is required by top managers in coming up with an objective function and rank the alternatives and make the best choice out of those alternatives. Impact of finance on the financial statements Financial statements such as the balance sheet, income statement, and cash flow statement are of great impact on a business and the investors as well. The information in those statements should be as accurate as possible because it can: Impact on stock price Stock price of a company can be determined by use of the financial statements. The investors will look at the financial statements before making their investment decisions. If the information on the financial statements is worse or better, the stock price may move up down or up. Financial ratios are normally used for formulation of assumptions. Impact on the outcome of financial decisions A business will seek financing depending on what is contained in the financial statements. Lenders will consider looking at the financial statements before extending a loan to a business. Attraction of new Investors Some information may attract new investors. For example, when a company wishes to issue new shares, it will first distribute the financial statements to any potential investor. The potential investor will then look at those statements in order to formulate a decision on whether to invest or not. Impact on Reputation A company’s reputation is greatly influenced by the financial statements. Bad numbers on the leading company may, sometimes result to a negative impact on other companies, thus drive down their stock prices. Part 2 Calculation of Unit Cost for North Seaton Engineering Company using Total Costing Method Information Annual turnover of the company = 500,000 Total Material Cost = £25,000 Total Labour Cost = £18 500 Total Manufacturing Overheads = £17 750 Total Factory Rent =£ 45 500 Number of units produced = 100, 000 Total Product Cost Total Material Cost £25,000 Total Labour Cost £18 500 Total Manufacturing Overheads £17 750 Total Factory Rent £45 500 Total Product Cost £106 750 Number of units produced 100, 000 Part 3 Assessment of a project using investment appraisal techniques In order to understand project assessment, this example will consider appraising two projects by use of Payback period and Net present value. North Seaton Engineering Company has the following two options. Each has an initial investment amount of £450 000. The capital cost will remain fairly static at 6% p.a. For project “A”, annual turnovers are as follows: Year 1: £ 180,000 Year 2: £23,000 Year 3: £280,000 Year 4: £120,00 Whereas for Project B it is: Year 1: £ 60,000 Year 2: £120,000 Year 3: £250,000 Year 4: £250,000 For project A, (cash flows in pounds) Cumulative Cash Flow Year Cash Flow 0 (450,000) (450,000) 1 180,000 (270,000) 2 23,000 (247,000 3 280,000 33,000 4 120,000 153,000 Payback Period = (p - n)÷p + ny ((280,000-23,000)/280,000) +2 =2.9 years (cash flows in pounds) Cumulative Cash Flow Year Cash Flow 0 (450,000) (450,000) 1 60,000 (390,000) 2 120,000 (270,000) 3 250,000 (20,000) 4 250,000 230,000 Payback Period = (p - n)÷p + ny (250,000-250000)/250000 + 3 = 3 years Net present Value PV Factors Year 1 = 1 ÷(1+6%)^1 ≈ Year 1 = 1 ÷(1+6%)^1 ≈ 0.9434 Year 2 = 1 ÷(1+6%)^2 ≈ 0.8899 Year 3 = 1 ÷(1+6%)^3 ≈ 0.8396 Year 4 = 1 ÷(1+6%)^4 ≈ 0.7921 Net Present Value for Project A Year 1 2 3 4 Net Cash Inflow £180000 £23,000 £280,000 £120,000 Total Cash Inflow £180,000 £23,000 £280,000 £120,000 × Present Value Factor 0.9434 0.8899 0.8396 0.7921 Present Value of Cash Flows £169812 £20,467.7 £235,088 £95052 Total PV of Cash Inflows £520419 − Initial Investment − 450,000 Net Present Value £70419 Project “B” Net Present Value Year 1 2 3 4 Net Cash Inflow £60,000 £120,000 £250,000 £250,000 Total Cash Inflow £60,000 £120,000 £250,000 £250,000 × Present Value Factor 0.9434 0.8899 0.8396 0.7921 Present Value of Cash Flows £56 604 £106788 £209900 £198025 Total PV of Cash Inflows £571317 − Initial Investment − 450,000 Net Present Value £121, 317 From an economic view, project A and B have a payback period of 2.9 and 3 years respectively whereas the net present value of project B is greater than that of project A. Therefore, since the net present value of project B is greater than that of A, project B is more favorable than A. Main financial statements There are four main financial statements. These include: The balance sheet Cash flow statements Income statements Statements of the shareholders’ equity Balance sheet A balance sheet will show what a company owns, with detailed information about the company’s assets, shareholder’s equity and liabilities. Income statement An income statement shows how the amount of revenue earned by a company over a certain period of time (Benjamin & Spencer, 1998). It shows expenses and costs that are associated with earning that amount of revenue. Cash Flow Statements Cash flow statements show the company’s outflows and inflows in terms of cash. This is helpful for a company to determine if it has sufficient cash at hand for settling some purchase assets and expenses. It a can also inform if a company has made profit or loss. Comparison of formats of financial statements for different types of business Horizontal format for a Balance Sheet Name Balance sheet as at XXX Sh Sh Sh Sh Capital xx Non Current Assets Land & Buildings xx Non Current Liabilities Plant & Machinery xx Loan xx Fixtures, furniture & fittings xx Motor vehicles xx Current liabilities xx Overdraft xx Current Assets Creditors xx xx Stocks xx Debtor’s xx Capital and Liabilities Cash at bank xx Cash in hand xx xx xx Total assets xx Vertical Format for a Balance Sheet Name Balance sheet as at 31.12. Non Current Assets Sh Sh Sh Land & Buildings xx Plant & Machinery xx Fixtures, furniture & fittings xx Motors vehicles xx xx Current Assets Stocks/inventories xx Debtors/ trade receivables xx Cash at bank xx Cash in hand xx Current Liabilities Bank Overdraft xx Creditors/trade payables xx (xx) Net Current Assets xx Net assets xx Capital xx Non Current Liabilities Loan (from bank or other sources) xx xx Format for the trading account: Name Trading Account for the year ended xxxx ₤ ₤ ₤ Sales x Less: Returns Inwards (x) x Less: Cost of Sales Opening stock x Purchases x Add: Carriage Inwards x x Less: Returns Outwards x x Cost of stock available for sale x Less: Closing stock x (x) Gross Profit x Interpreting financial statements using the appropriate ratios and comparisons, both internal and external There are 5 classes of ratios: Liquidity Leverage/Gearing ratios Activity Ratios Profitability Equity / Investor ratios. In order to fully understand this concept, consider the P & L account below and the balance sheet in the figure below: LIQUDITY RATIOS Current Ratio = For R Ltd, =2: 1 For P Ltd, = = 5: 1 The higher the ratio then the more liquid the firm is. Quick Ratio/Acid Test Ratio Quick ratio = For R Ltd, = = 0.8333: 1 For P ltd = = 0.8333: 1 This ratio is more refined and recognizes the fact that some stakes cannot be converted to cash in an easy way. Therefore, the higher the acid test ratio, the better the firm’s position because it means there is improved liquidity position. GEARING RATIOS Debt Ratio = For R Ltd =2.333 For P Ltd = 0.8333 This ratio measures the proportion of total assets financed by non owner supplied funds. The higher the ratio, the higher the financial risk . PROFITABILITY RATIOS Profitability in Relation to Sales Gross Profit Margin = For R Ltd, = 0.24 For P Ltd = 0.375 The higher the margin, the more profitable the firm is. Net Profit Margin For R Ltd = = 0.1 For P Ltd = The higher the margin, the more profitable the firm is. Margin affected by: Operating expenses for the period Profitability in Relation to investment Return On Capital Employed For R Ltd = 0.2083 =20% For P Ltd =0.5 50% How efficient the firm has been in using the net assets to generate returns in the business. Conclusion In brief, financial statements are very crucial in any business organization. A business requires different financial sources, which have got different costs, advantages and disadvantages. The information contained in the financial statements can, therefore, be used in interpreting financial statements. Appraisal techniques are also useful in deciding between two competing projects. Works Cited Benjamin, Graham, & Spencer, Meredith. The Interpretation of Financial Statements: The Classic 1937 Edition , 1998. Print. Brian, Rutherford. An Introduction to Modern Financial Reporting Theory. London: SAGE Publications Company, 2010. Print. David, Hey-Cunningham. Financial Statements Demystified. Crows Nest: Allen & Unwin , 2006. Print. Martin, Fridson, & Fernando, Alvarez. Financial Statements Analysis: A Practitioner’s Guide. New Jersey: John Wiley & Sons Ltd , 2011. Print. Pamela Drake, & Frank, Fabozzi. Analysis of Financial Statements. New Jersey: Wiley & Sons,2012. Print. Read More